High Quality Dividend Stocks, Long-Term Plan

Blue Chip Stocks in Focus: Bank of Nova Scotia

Before showing you an example, it’s important to understand what a blue chip stock really is.

There is no ‘formal’ definition of a blue chip stock that is widely accepted among financial professionals. The term is used to describe high-quality, economically durable companies that are likely to continue profitable operations for a long, long time.

At Sure Dividend, we define a blue chip stock as a company with a 100+ year operating history and a 3%+ dividend yield. These two characteristics mean that:

The company has a business model that has endured through many market cycles and is likely to last well into the future.

The business pays a nice dividend, which allows long-term investors to profit without reducing or eliminating their ownership stake.

Our blue chip stocks list is not necessarily constrained to companies in the United States.

The Bank of Nova Scotia (BNS) is one example of an international issue with robust growth prospects from our blue chip stocks database.

This financial institution – which is most notably known for its strong performance during the 2007-2009 financial crisis and its growing presence in Latin America and South America – is one of the ‘Big Five’ Canadian banks, which form a veritable oligopoly in the Canadian financial services industry.

This article will analyze the investment prospects of The Bank of Nova Scotia in detail.

Business Overview & Current Events

The Bank of Nova Scotia (or Scotiabank, for short) is the third-largest financial institution in Canada, behind:

Scotiabank recently reported financial performance for the second quarter of 2017. The fiscal years of each of the Canadian banks begins on November 1, which means that the end of the second quarter falls on April 30.

Scotiabank’s performance in the quarter was quite strong. Diluted earnings-per-share increased by 11%, in-line with the growth in company-wide net income. This indicates a stable share count.

Other key performance figures include revenue growth of 4% (lower than normal for Scotiabank) and expense growth of 5% (also lower than normal). All said, it was generally a ‘business as usual’ quarter for this bank.

Scotiabank is highly differentiated from its peers in the Canadian financial services industry due to its extensive retail presence in international markets.

While most of the Canadian banks have turned to the U.S. as their primary growth driver, Scotiabank has turned to Latin and South America, particualrly its ‘Pacific Alliance’ countries which includes Mexico, Chile, Columbia, and Peru.

There are many advantages to Scotiabank’s focus on this region, which are discussed in detail in the next section.

Growth Prospects

Looking ahead, I believe Scotiabank’s growth will be driven by two primary initiatives.

The first is the aforementioned expansion into South America & Latin America.

This is a tremendous opportunity for Scotiabank for two main reasons.

First, the interest rate environment in these countries is much preferable to the environment in Canada, largely due to the increased risk of lending to consumers in these developing nations. For Scotiabank, this means that disciplined credit underwriting can create a compelling competitive advantage.

For evidence of the favorable interest rate trends in Scotiabank’s International Banking segment, simply compare the unit’s net interest margin – which is the difference in interest rates between loans and deposits, and measures how much interest revenue is generate for each dollar of loaned money – to Scotiabank’s Canadian Banking segment

The Canadian banking segment has posted net interest margin just shy of 2.4% in recent quarters. In addition, Scotiabank’s Canadian Banking segment posted adjusted net income growth of 11% in the most recent quarter.

Secondly, I expect Scotiabank’s International Banking segment to continue posting extremely strong growth because it is targeting economies that are historically under-banked.

As these economies continue to develop, the demand for financial products will grow, creating more business for Scotiabank.

Scotiabank’s other main growth driver is the growth in online banking.

In 2012, Scotiabank acquired Tangerine, which is Canada’s largest online-only bank and known to consumers as the leader in low-cost banking products. The tradeoff for these low fees is the lack of a dedicated branch network. Tangerine’s only physical support centers are the Scotiabank ATMs located across the country.

I believe that the continued shift to online banking will be a major tailwind for Scotiabank because of its timely 2012 acquisition of Tangerine.

Competitive Advantage & Recession Performance

Scotiabank’s major competitive advantage is the regulatory hurdles associated with entering the Canadian financial services industry. In addition, Scotiabank’s size (the third largest bank in Canada based on market capitalization) allows it to generate meaningful economies of scale.

Scotiabank – like most providers of financial products – also benefits tremendously from the ‘stickiness’ of its products. Simply put, customers are highly unlikely to switch to another financial services provider due to the time and costs associated with making the transition.

What really stands out about this bank is its performance during periods of recession, particularly when compared to some of its U.S. counterparts.

For proof of Scotiabank’s recession resiliency, consider the company’s performance during the Global Financial Crisis of 2007-2009 (when many other financial institutions were going out of business):

2007 adjusted earnings-per-share: $4.03

2008 adjusted earnings-per-share: $3.06 (24.1% decrease)

2009 adjusted earnings-per-share: $3.31 (8.2% increase)

2010 adjusted earnings-per-share: $3.91 (18.1% increase)

2011 adjusted earnings-per-share: $4.62 (18.2% increasse)

Scotiabank experienced a peak-to-trough earnings decline of 24% during the financial crisis, which bests the performance of many of its U.S. peers.

Importantly, Scotiabank did not cut its dividend during the financial crisis, instead just freezing its streak of steady increases and keeping its dividend payment constant for a single year.

These observations indicate that Scotiabank was well-capitalized and conservatively managed during the last crisis, two characteristics which likely hold true in today’s version of this high-quality financial institution.

Valuation & Expected Total Returns

Scotiabank’s expected total returns can be calculated by accounting for its expected earnings-per-share growth, valuation changes, and its current dividend yield.

Historically, Scotiabank has done a tremendous job of compounding its bottom line over long periods of time.

Since 2001, the company has grown its adjusted earnings-per-share at a rate of 7.2% per year. The company’s full earnings-per-share trend during this time period can be seen below.

Looking ahead, Scotiabank’s management team believes the bank will deliver earnings-per-share growth of 5%-10% over the long-term. I believe investors can reasonably expect the bank to meet this level of growth, consider it aligns with its historical growth rate (even through a 15-year period containing the financial crisis).

The ‘Trump bump’ since November has elevated the valuations of many financial stocks. Fortuntely, Scotiabank still trades at a reasonable earnings multiple today.

Scotiabank reported earnings-per-share of C$6.00 in fiscal 2016. The company’s current stock price of C$77.79 is trading at a price-to-earnings ratio of 13.0 using 2016’s earnings.

Scotiabank’s valuation can also be assessed using an estimate of 2017’s earnings-per-share.

The company’s management team expects 5%-10% earnings-per-share growth moving forward. Applying the lowest growth rate from this guidance (5%) to 2016’s earnings-per-share gives a 2017 estimate of $6.30, equating to a price-to-earnings ratio of 12.3 using the company’s current share price.

The following diagram compares each of these valuations to Scotiabank’s long-term historical average.

Scotiabank’s current price-to-earnings ratio of ~13 is slightly above its long-term average price-to-earnings ratio of 12.1.

With that said, I believe the company is still in buy territory thanks to the tailwinds of rising domestic interest rates and continued growth in its international operating segment.

Lastly, Scotiabank’s investors will be rewarded by the company’s juicy dividend yield, which currently sits at 3.9% – more than double the average dividend yield within the S&P 500.

Scotiabank is very likely to continue raising its dividend over time. As of late, the bank has been executing two dividend increases per year amount of $0.02 per increase. From today’s current dividend payment, this amounts to 5.3% annualized dividend growth moving forward.

In sum, Scotiabank’s total return profile is composed of:

5%-10% earnings-per-share growth

3.9% dividend yield

for expected total returns of 8.9%-12.9% before the impact of any valuation changes, which may create a slight drag on future performance if Scotiabank’s valuation reverts to its historical mean.

Final Thoughts

Scotiabank has many of the characteristics of a great long-term, buy-and-hold investment:

In addition, Scotiabank’s valuation is quite close to its long-term historical mean. Buying great companies at fair prices – the strategy employed by legendary investor Warren Buffett – is a fantastic method for building long-term wealth.

All signs indicate that Scotiabank is a buy at current prices.

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